The size and scale of the commercial real estate market make it an attractive and profitable sector for many investors. But understanding the drivers of commercial property returns is important so that you can see how well your investment will perform.
Investment returns are generally created from both changes in the cash flow generated from the underlying asset (income return) and the asset value (capital return).
Here we explain those two concepts in more detail before evaluating the drivers that impact them.
Capital Return
Commercial investment property’s value is largely derived from its dependable regular rental income.
However, certain market forces can mean the capital value can change quite significantly depending on the supply and demand for investment stock at any given time.
Income
The main source of return from commercial property investment, is the rent paid by the tenants on a regular basis as set out in the lease agreement, according to the Investment Property Forum
In their 2017 report Understanding UK Commercial Property Investments, they explain that over the long term, this is likely to make up most of the total returns that may be achieved.
Leases on commercial property are generally for 5 or 10 years – sometimes even longer – which means a commercial property investment has potential for a regular income that continues through the life of the lease.
In many cases, the rent can only be revised upwards when they are reviewed which is normally every five years.
It is important to be aware of the key differences between the leases for commercial and residential assets, as the latter tend to be let on shorter leases, generally one to three years, and offer the tenant termination sooner in the contract.
In commercial assets the business tenant is responsible for insuring and repairing the premises, however with residential the landlord is responsible for maintenance and management costs leading to a depletion in gross income. However, residential income can be more predictable over the longer term, as the size and length of the tenant voids are likely to be smaller than for commercial property.
The Key Drivers Of Property Performance
Now let’s take a good look at the key drivers on these two investment returns.
Demand and supply
The market is a huge influence on the rent at which a property will let or the price at which a property will sell.
Solid demand from prospective tenants for popular buildings will lead to an increase in the rental value of that space, particularly if there is a physical limit on supply, for example, a shop in Oxford Street in London’s popular shopping district.
Landlords do not have to offer tenants so much in the way of motivations, such as rent-free periods, to take the lease in these conditions. For example, when market rents are increasing, the length of the rent-free periods being offered falls and the reverse is true when rental values are static or falling.
Where there is greater investor and tenant demand, capital values rise. For example, the capital value of trophy assets in the centre of London have grown more rapidly in value than property in the rest of the UK because of the high level of international investor demand.
It is important to note that movements in capital and rental values are not perfectly positively connected, and it is possible for the investment value of an asset to increase faster or slower than its rental/occupational value.
Rent Reviews
Rent reviews for commercial property generally take place every five years in the UK and tend to go upwards only.
However, there are other mainstream provisions:
- Turnover-related rents.These leases are most common in the retail sector. They are set as a percentage of the tenant’s business activity turnover from inhabiting the space. Whilst such provisions often include a base rent which can be relatively low, turnover-related rents are less certain and more volatile than five-year, upward only leases and are more difficult to value.
- Index-linked rents: these are rents that are connected to an index such as the Retail Price Index (RPI). They have been increasingly used by the UK investment market as they provide inflation hedging.
- Fixed uplift rents: these are rents that are uplifted after a designated period, for example every three or five years, by a set value or percentage as stated in the original terms of the lease;
Tenants with more floorspace are more likely to want a longer lease because of the cost of relocating and fitting out a new premise.
Some leases include a ‘break clause’ that gives the landlord and/or tenant the option to terminate the lease prior to its expiry date. This can impact the value of a property because the income stream is no longer certain for the full term of the lease.
Covenant Strength
Commercial property returns can also be impacted by your company’s covenant strength – which is essentially the financial stability and profitability of the company. This relative strength will be measured by looking at your company’s accounts, taking up references, assessing your track record and whether your business can realistically afford the rent.
For instance, the share prices of two engineering companies producing similar products may differ because of the market rating of each company.
Likewise, the investment value of two similar buildings occupied by tenants paying exactly the same rent will differ if there is an apparent difference in covenant strength between the two tenants.
Lease Length
Commercial property leases in the UK typically range between 5 and 15 years in length, with the market average currently being around seven years, according to the 2017 UK Lease Events Review, published by MSCI, in association with BNP Paribas Real Estate.
Different sectors and sub sectors can also command varying lease lengths, for example retail warehouse tenants generally want longer leases than those occupying standard unit shops.
The size of the space and location also have a bearing on the length of the lease. With regard to location, tenants occupying offices in central London may want greater flexibility and therefore shorter leases than office tenants in towns and cities elsewhere in the UK.
Asset Management
Asset management includes the collection of rent, the administration of contractual lease terms such as rent reviews, the arrangement and recovery of insurance if the property is multi-occupied and the provision of maintenance and services in common areas of the property.
It may be possible to add value over that reflected in market pricing through active asset management, such as by undertaking refurbishments and redevelopment, extending leases or by ‘right-sizing’ tenants – providing them with the optimum sized unit.
However, market conditions greatly influence the final terms agreed, for example tenants are often able to secure shorter leases in periods of over-supply and may have to take longer leases at times of limited supply.
Use Of Debt Finance
Leveraging debt finance can also impact the investment performance of a property. For example, it can be used to increase the return on equity during an upward or stable market.
However, this could exacerbate negative returns in a falling market, because there is an increase in risk when using debt finance to increase returns, as markets tend to move up gradually over long periods and suddenly decrease during crashes.
